Exchange rate volatility has intensified as policymakers fall out of sync
- In recent years, the USD has appreciated through a combination of risk-aversion, growth outperformance, and rising interest rates. This trend has intensified at the beginning of 2024 as sticky inflation in the US has underpinned a divergence in expectations around the timing of the policy pivot for major central banks.
- While the US Fed is now expected to hold out until September or even December, the ECB is almost certain to begin cutting in June. Meanwhile, the PBoC has been easing policy for a while now in support of the Chinese domestic economy, while the Bank of Japan is taking tentative steps to exit their ultra-loose policy environment.
- This has put pressure on global currency markets, and some policymakers have been forced into action, including the Bank of Japan, after the yen approached 160 against the USD in late April, the highest in nearly four decades. So this week, we take a look at the impact of currency, and how real estate investors mitigate the risks of volatile exchange rates.
- Currency can have a major impact on investor returns (both on an absolute and risk-adjusted basis), either via realised cashflow when repatriating income to home markets, or via the balance sheet, as foreign assets are revalued with currency impacts.
- Consider, for example, the MSCI Global Annual Property Index, which has delivered a fully hedged annualised return of 6.8% over its entire history (2001-2023). For an unhedged Swiss investor, the return over the same period was just 4.2%. Conversely, with the yen losing value against major trading partners over the last few decades, returns for unhedged Japanese investors averaged 8.5%, albeit at a much higher volatility.
- Currency can also impact the performance of underlying assets in so far as it feeds into economic outcomes. An undervalued currency can boost the competitiveness of a country’s exports, for example, and so by implication, the industrial & logistics facilities required to facilitate the production, transportation, and storage of those exports.
- This has been the case in Germany, which has been a major beneficiary from the introduction of the single currency in Europe over two decades ago, supporting a large positive current account surplus (i.e., the difference between trade in goods and services, and net capital inflows). Major swings in foreign exchange rates can also lead to inflation via the cost of imports, and thus influence the policy decisions of central banks.
- For real estate investors, while little can be done to mitigate against these economic factors, many will look to hedge against cashflow/balance sheet risk. This makes sense, for there are much easier ways to take a view on currency than to buy foreign illiquid assets. A 2016 survey conducted by INREV found that over 70% of institutional investors hedge currency risk.
- Larger institutions with a global presence may be able to do this at the entity level, by offsetting currency risk across a wider portfolio of assets in different locations. Some investors may also look to raise equity or debt in the same currency as their planned investments, to better align asset and liability flows.
- For smaller investors buying individual assets, the most effective hedging method is to use financial derivative products. There are many ways to do this, but effectively, it means paying or receiving the differential in interest rates.
- This is based on a simple arbitrage condition; if an investor needs to sell US dollars and buy Japanese yen in one year from today, for example, then they should be indifferent between transacting at spot rates today and earning interest in Japan over the next year (where deposit rates are basically zero), or committing to a fixed exchange rate in one year while continuing to earn interest in the US now (at a deposit rate in excess of 5%).
- The implication of this is that investors domiciled in high interest rate markets, such as in the US, or a country with a USD-pegged currency, can generally earn a positive carry by hedging exchange rate risk, boosting their returns on any cross border investment. Looking across the major global real estate markets, we can use interest rate differentials to give a very broad, albeit very simplified, perspective on where investors can benefit from this positive carry. This is illustrated in the table below, and is based on current 2-year government bond yields.
- Finally, some investors will see currency fluctuations as an opportunity to enter a market at a relative discount. For USD-denominated/pegged investors, property in Japan is currently around 13% cheaper than in was 12 months ago, simply due to the depreciation in the yen exchange rate over this period.
- If taking the view that the yen is currently undervalued relative to fundamentals, and that current weakness is primarily due to cyclical reasons, then in theory, now would be a good time to buy Japanese real estate. This echoes some of the anecdotal discussions that happened in the UK following the Brexit-referendum in 2016, with sterling losing around 10-15% in value in the immediate aftermath of the leave vote.
- Investment data, however, rarely correlates with currency movements. Those investors more inclined to take currency risk, such as private investors, are typically smaller in scale and so do not tip the scale when looking at the aggregate market. But perhaps more pertinently, a weak currency is often symptomatic of wider structural issues. Cross border investment into the UK, for example, fell by 26% on the year in the second half of 2016, given concerns over the economic impact of leaving the European Union. Japanese investors, meanwhile, purchased nearly JPY 1.4 trillion of non-domestic real estate assets in 2023, nearly double the previous record for outbound investment, despite the weak yen and negative carry.
- In summary, exchange rates will feed into investor decisions at the margin, and support a wider investment thesis on when and where to invest. But they are by far from the main factor, and given the challenges in forecasting exchange rates, most investors will try to mitigate against volatility, rather than take the risk.
